5 Things You Need to Know About This Restaurant’s IPO

William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

On June 28, restaurant chain Noodles & Company (NASDAQ: NDLS) went public at $18 per share meeting with much enthusiasm from investors as its stock price shot up to its current price of $40.06 per share, as of this writing, increasing a full 123% in little over a week. The question for you, the investor, is: Should you jump in now? I perused the prospectus form 424B4 and found five things that will help you answer that question.

Reduced reporting requirements

At the very top of the prospectus the statement reads “Noodles & Company is an ‘emerging growth company’ as defined under the federal securities laws and, as such, may elect to comply with certain reduced public company reporting requirements in future reports after the closing of this offering.”

According to the website martindale.com, under the Jumpstart Our Business Startups Act of 2012, a small company that meets certain criteria can forego certain reporting obligations such as the internal control attestation requirement under Sarbanes-Oxley. For you the investor, this means a slightly heightened level of information risk as the internal controls may or may not guarantee accurate financial statements.

Free cash flow negative

Noodles & Company’s free cash flow resides in the negative range, which means the company spends more than its operating cash flow on things such as capital expenditures on store expansion. From an owner’s standpoint, this mean the company will need to dilute shareholders through equity financing or take on debt to maintain and expand operations.

The reason for this lies behind company ownership of most of its stores. As a business owner, you want your business to generate cash. Moreover, you would want as many partners footing the bill as you can. Typically restaurant businesses bring in franchisees to help finance expansion. Franchisees do some of the heavy lifting on things such as leases, wages, and capital expenses.

As of the end of 2012, Noodles & Company’s free cash flow margin clocked in at negative 5%. Franchisee operated restaurants comprised only 16% of the Noodles & Company chain as of the end of April.

By contrast, 80% of McDonald’s (NYSE: MCD) restaurants are operated by franchisees. McDonald’s free cash flow margin came in at 14% in 2012.Franchisee operated restaurants make up 77% of Yum! Brands (NYSE: YUM) restaurants. Its free cash flow margin came in at 9% in 2012. Chipotle Mexican Grill (NYSE: CMG), another restaurant chain with mostly company operated stores, sported a free cash flow margin of 8% as of the end of 2012, a little lower than McDonald’s and Yum! Brands.

Currently Noodles and Company plans to focus on its expansion of company owned stores, meaning that free cash flow margins will remain suppressed due to the heavy capital expenditures involved.

Low net profit margins

In addition, Noodles & Company’s net profit margins come in at 2% which is more comparable to grocery store chains than restaurants. McDonald’s, Yum! Brands, and Chipotle Mexican Grill all scored profit margins of 20%, 12% and 10% respectively as of the end of 2012. The results for Noodles & Company don’t provide shareholders with a good margin of safety.

McDonald's, Yum! Brands, and Chipotle Mexican Grill represent more profitable and established companies in the publicly traded arena. With the global reach of McDonald's, Yum! Brands, and Chipotle Mexican Grill growing quickly in that direction you may want devote more research time to these three companies. The ubiquity and high franchise ownership will allow McDonald's and Yum! Brands to maintain better margins. Chipotle Mexican Grill's focus on quality food will give this company an edge over Noodles & Company who constantly talked about customer experience in its prospectus. Positive customer experiences begins with high quality food.

Market risk

The high market risk stemming from the recent triple digit run up in stock price may cause concern. As of this writing, Noodles & Company trades at an astronomical P/E ratio of 203 compared to the current S&P 500 P/E ratio of 19. In comparison restaurant growth darling Chipotle Mexican Grill sports a P/E of 42, McDonald’s 19, and Yum! Brands 23. As you can see, cheaper fish swim in the sea.

IPO proceeds to pay down debt

Noodles & Company plans to use the IPO proceeds to pay down debt. After it does this its long-term debt to equity ratio will go from 901% to roughly 14%, representing a prudent use of IPO funds. Moreover, this will give the company breathing room due to the fact that 2012’s operating income only exceeded interest expense by three times.

Looking ahead

Noodles & Company plans to expand from its current store base of 343 to about “2,500 in 15-20 years.” This represents an ambitious plan; however, investors should proceed with caution. Noodles & Company comes with elevated information risk due to its status as an “emerging growth company”. Expect low margins to persist as Noodles & Company insists on opening company owned stores. The company’s high valuation will make Mr. Market very nervous. Expect the stock to plummet on any bad news. Growth company Chipotle Mexican Grill, McDonald’s, and Yum! Brands may serve as better places for your money. You can add Noodles & Company to the Motley Fool Watch List (sign in required) and reconsider buying when fundamental conditions improve.

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William Bias owns shares of McDonald's. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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